economy

What If Lehman Happened Today?

The euro crisis could trigger another American bank failure. Wall Street is better prepared this time, but U.S. regulators still haven’t mapped the new financial universe, written rules for it, or ramped up enforcement.

By Michael Hirsh and Stacy Kaper

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Object lesson: The Lehman
Brothers building in 2008.(AP Photo/Mark Lennihan)

Slight, balding, and a bit birdlike in appearance, Gary Gensler is no one’s idea of a biblical David. But Gensler, chairman of the Commodity Futures Trading Commission, is fighting Goliath, and not just one Goliath—he’s challenging several at once. The stakes couldn’t be higher: If he doesn’t win, it’s possible that America could suffer a repeat of the 2008 crash.

There’s the Wall Street lobby, which never stops trying to open giant loopholes in the still-evolving Dodd-Frank regulatory overhaul from 2010 that Gensler is trying to implement. There’s the Republican-controlled House, which opposes Dodd-Frank, generally tries to make every loophole bigger, and (along with the Senate) recently sought to gut reform by slashing the CFTC’s budget request by a third. Making the fight even lonelier for Gensler is the coming retirement of one of the law’s chief champions, Rep. Barney Frank, D-Mass.

And now Gensler—a former Goldman Sachs executive whose stand against his erstwhile Wall Street comrades has won praise from progressives—is facing down the biggest Goliath of all. Europe’s raging financial crisis may not leave Gensler the time he needs to get a handle on the vast global market in derivatives, the arcane instruments used to bet on everything from interest rates to currencies to credit default swaps on the Continent. At $708 trillion (yes, trillion), the derivatives trade is already much larger than it was during the 2008 crisis. Just as last time, this opaque market may hold the key to whether the evolving eurozone disaster causes another market meltdown worldwide. With a staff of only 712 (roughly unchanged from the 1990s, when financial products where much less complex), the CFTC must regulate markets seven times the size of the futures market it used to oversee. Mostly, it supervises America’s $300 trillion portion of the global derivatives trade. “Until we complete this task, the American people remain at risk,” Gensler warned in an interview with NationalJournal at his office in downtown Washington. “We are midstream” in rule-writing and in requiring firms to report their trading positions, he admits. “The only thing that we would have right now is the data that banks and others are voluntarily reporting.” Even after the rules are written, Gensler says, “we won’t necessarily have the cops on the beat to oversee the market.”

Between the deepening euro crisis, political stalemate in Washington, a stubbornly slow recovery haunted by the threat of double-dip recession, and the vast deadweight of underwater housing, time is not on Gensler’s side. Market experts wonder whether another Lehman-type event is lurking—the failure of some large bank that could come out of nowhere and trigger a chain reaction. Just look at the ominous Halloween failure of MF Global Holdings, a broker-dealer that overloaded itself with European debt. If it happened, many critics fear that the regulatory response would hardly be better than it was last time, when every senior official from the Treasury secretary to the Federal Reserve Board chairman was caught by complete surprise.

UNPREPARED

It’s true that, with the wounds of 2008 still smarting, Wall Street is far more risk-averse than it was then, and U.S. banks are generally in stronger shape. They are flush with cash, making it easier to cushion shocks. “The United States banking system is a lot better capitalized than it was going into the crisis,” Treasury Undersecretary for International Affairs Lael Brainard said recently. Crisis-tested regulators remain on high alert, are in more routine communication with each other and their counterparts abroad, and are vigilant about ensuring that banks reduce their exposure. A senior U.S. regulator said that American banks likely have less than $45 billion in direct loan exposure to European banks. The Fed has begun a new series of stress tests focused on euro-debt exposure. Banks must turn in their results in January; the central bank plans to release its findings in March.

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But the euro calamity has now become a debt and liquidity crisis with unnerving similarities to 2008. Instead of scads of bad housing debt, this time the culprit is dubious government debt. This time, too, there could be a run on the entire financial system. European bonds have fallen under such market suspicion that even powerful Germany failed to sell off all of its bonds at an auction last month. As in 2008, one of the greatest fears of catastrophe lies not in direct loans to European countries or companies but in the murky world of derivatives, especially in credit default swaps, which are intended to insure buyers of debt against default. “I don’t think regulators have a good handle on how well the CDS market will hold up if there is a major credit default in Europe,” one recently retired regulator, Sheila Bair of the Federal Deposit Insurance Corp., told NationalJournal.